Investors who redeem fund shares face the real risk that they'll forfeit part of
their profit by overpaying their tax bill. Veteran investors already know what a pain it
can be to sort out the tax consequences of redeeming shares.

Even if you don't redeem shares in a given year, you'll owe tax on dividend and capital-gains distributions — your share of income from securities in the fund and
your cut of the profits managers scored on trades inside the fund. The fund will report
this income to you on a Form 1099-DIV. It's taxed on your return even if the money was automatically reinvested in
additional shares. (Funds in tax-deferred accounts, however, require little record keeping
until you begin withdrawing money.)

Don't Double Pay

The biggest mistake many fund investors make when they pay their income taxes is
suffering amnesia about their reinvestment of dividends and capital gains in additional
shares of a fund.

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Say you buy 100 shares of a stock fund at $10 per share, for a total of $1,000. At the
end of the year, the fund pays you a distribution of $1 per share in long-term capital
gains and 50 cents per share in dividends — or a total of $150, which is reinvested in
additional shares.

The fund company sends you a 1099-DIV form listing those distributions, and you
dutifully copy the numbers onto your income-tax return for that year. (Funds that hold
bonds and some income-oriented stock funds often pay distributions quarterly or monthly.)

The following year, you sell your shares of the fund. The fund sends you a final form
— this one listing the total amount you received when you sold the fund. Let's say
you sold your shares for $1,500.

When you sit down to do your income taxes for that year, you record that you paid
$1,000 for your shares and sold them for $1,500. Therefore, you have a capital gain of
$500 — from which Uncle Sam gets his cut.

Not so fast!

You forgot about the $150 in capital gains and dividends you had reinvested.
You've already paid taxes on that $150. Since you reinvested that money in extra
shares, you really paid $1,000 plus $150, or $1,150, for the shares you sold. Subtracting
$1,150 from $1,500, your real capital gain on selling the fund is not $500, but only $350.

Many investors hold a fund five, ten or 20 years, reinvesting dividends and capital
gains every year. Unfortunately, when they sell their shares, they neglect to add to the
the cost of their original investment (called the cost basis) the value of the money they reinvested over the years.

Basis Basics

Figuring your basis gets trickier if you sell just part of your position. Unless you instructed the
fund specifically which shares to sell, you have two choices for figuring your basis:
first-in/first-out (FIFO) and average basis. (If you had the presence of mind to tell the
fund exactly which shares to sell, it's the basis of those shares that you use to
figure your profit or loss.)

With FIFO, you have to go through your records to find out how much you paid for the
shares you owned the longest. Say, for example, that you bought 100 shares for $20 per
share in 2006, another 100 shares at $30 in 2007, and another 100-share block at $50 in
2008.

Then, in 2009, you sold 150 shares. Using FIFO, your basis would be $3,500, because you
are considered to have sold all 100 $20 shares ($2,000) plus 50 of the $30 shares
($1,500). If your records are in bad shape, FIFO can give you a serious headache.

The average basis rule provides some relief. Your average basis is the total amount
you have invested in a fund divided by the total number of shares you own.

In the example above, your average basis would be $33.33 per share: the total
investment of $10,000 divided by 300 shares. And the basis of the 150 shares sold would be
$5,000.

Since that's $1,500 more than it would be using the FIFO method, average basis
would cut your taxable profit by $1,500, and that would save you $300 in taxes. With
either method, you'll ultimately pay tax on the same amount of gain when all shares
have been redeemed.

This is fast becoming the method of choice for fund investors, primarily because many
funds (and some of the discount brokerages from which you can buy funds) automatically
provide you with average-cost-basis information.

All you have to do is copy onto your tax form the information from the statement the
fund sends you at the end of each year in which you've sold shares.